Why Investors Should Seek Alpha in Frontier Markets

Less-developed economies offer the possibility of huge rewards — but the risks can be just as great.


Investing these days can feel a little like deciding between the lesser of two (or more) evils. The European debt crisis drags on, with myriad unresolved issues, while the U.S. continues its struggle to tamp down the unemployment rate and rev up the economy. Gone — at least for now — are the days of blistering growth in such emerging markets as China, India and Russia. Those economies are still expanding, but at slower rates than in recent years.

Enter the frontier markets, which are attracting interest from buy- and sell-side firms as investors seek opportunities they can’t find elsewhere. “These are places with very underdeveloped markets,” explains Andrew Howell, an emerging- and frontier markets equity strategist at Citi. “They’re places with huge potential growth but still very significant political, social and economic uncertainties, so it’s far from a sure thing that these guys are all going to be successful. But if they are successful, there’s enormous upside.”

Is there ever. Sri Lanka’s stock market, for example, skyrocketed nearly 188 percent in the three years through April, trouncing the Standard & Poor’s 500 index by more than 150 percentage points. Romania bolted nearly 80 percent. Overall, however, frontier markets rose only 15.1 percent over the period, which means that choosing the right markets — and the right stocks within those markets — is crucial.

Howell published a report in November, “Call of the Frontier: The Search for a New Generation of Emerging Markets,” to help investors make the right choices. He identified 15 countries — Argentina, Bangladesh, Kenya, Mongolia, Nigeria, Pakistan, Romania, Sri Lanka, Ukraine and Vietnam, among others — that he believes have “the potential to generate the kind of returns for equity investors over the coming decades that the emerging markets themselves have produced over the past quarter-century.” (Neither MSCI nor S&P includes Mongolia in its frontier markets index, although many analysts and investors view the country as comparable to those economies. Its stock market catapulted 309.3 percent in the three years through April.)

1 Tunisia


2 Pakistan 3.40
3 Qatar 3.36
4 Lithuania –0.79
5 United Arab Emirates –6.67
6 Nigeria –6.85
7 Jordan –6.99
8 Bangladesh –7.71
9 Kenya –10.85
10 Estonia –11.22
1 The best-performing frontier markets in the year through April. The Standard & Poor’s 500 index inched up 2.5 percent over the period.
2 Performances are in local currencies. The index for Bangladesh (launched November 2009) does not qualify for inclusion in the three-year ranking.

Analyst coverage varies as widely as frontier markets’ performance. Howell, who is based in London, estimates that there are, on average, 4.7 recommendations per frontier market stock, compared with 16.4 for those in developed markets and 14 for stocks in emerging markets. “In pretty much every frontier market, you’re going to have some broker somewhere who covers it,” he says. “Whether or not the broker’s view has any validity or sophistication is hard to say.”


Given the variation in both the quality and quantity of sell-side research, fund managers often take to the road for a firsthand look at the companies. Timothy Drinkall, New York–based manager of the $85 million Morgan Stanley Investment Management Frontier Emerging Markets Fund — part of a larger pool of more than $370 million in frontier market assets managed by the firm — often takes two weeklong trips each month.

Oliver Bell, who oversees T. Rowe Price Associates’ $300 million Africa & Middle East Fund, is on the road at least one week each month. “You really need to get in front of managements and find out what they’re planning to do, and then compare what they’ve done to what they told you the last time,” the London-based money manager says. “Ultimately, it’s the best-managed companies that do well in these markets. Because of the volatility of the macroeconomics you tend to get, you need to find managements that know how to ride the turbulent times and benefit from the good times.”

Citi’s Howell estimates that institutional money managers worldwide have $12 billion invested in frontier market funds — and that figure will rise. “You’re going to see more of the broader pan-frontier-market funds launched,” he declares.

Andrew Brudenell, head of frontier markets equity strategy and senior portfolio manager of HSBC Global Asset Management’s $150 million GIF Frontier Markets Fund, agrees. “We’re seeing people who spent time looking at the asset class in 2007 and 2008, didn’t get in and then didn’t look at the space until 2009 because perhaps there was easier money to be made in emerging markets — which they kind of knew better and for which they didn’t need to do as much due diligence,” observes Brudenell, who works out of London. “But once those rebounded quite strongly in 2009 and seemed to already have done their thing in a fairly short space of time, we began to see a lot more people asking about frontier markets.”

As investor interest is rising, so is the level of sell-side research. About 18 months ago “we took a view that frontier markets were underresearched and thought we would roll out coverage,” says Rhys Summerton, Citi’s London-based head of research for Central and Eastern Europe, Middle East and Africa. The firm has been selective, emphasizing Argentina, the Middle East and North Africa, and sub-Saharan Africa.

Russia’s Renaissance Capital is also boosting coverage of the latter region, according to David Nangle, Moscow-based head of research. From its office in Lagos, “you see Standard Bank of South Africa around the corner, but you don’t see Morgan Stanley or Goldman Sachs there yet,” he says. “The day will come, obviously, but it’s not the right time.”

Part of the reason, according to T. Rowe Price’s Bell, is that “the return for the sell side isn’t high at the moment.” Even CLSA Asia-Pacific Markets, known for its strong network in markets across Asia, doesn’t cover frontier stocks yet, although its analysts do report on such Hong Kong–listed offerings as Mongolian Mining Corp. and SouthGobi Resources, a Vancouver, Canada–based company that operates mines in Mongolia.

1 Sri Lanka


2 Romania 79.39
3 Lithuania 74.76
4 Estonia 73.80
5 Qatar 64.61
6 Pakistan 64.24
7 Serbia 51.57
8 Kenya 44.86
9 Mauritius 39.52
10 Vietnam 38.00
1 The best-performing frontier markets in the three years through April. The Standard & Poor’s 500 index rose 37.6 percent over the period.
2 Performances are in local currencies. The index for Bangladesh (launched November 2009) does not qualify for inclusion in the three-year ranking.

“We will initiate company research in these markets if and when we open up an office and can execute trades directly,” says Amar Gill, Hong Kong–based head of Asia research. Late last month the firm took its first step toward doing just that by entering into an agreement with Mongolia’s largest brokerage, BDSec, to provide foreign institutional investors access to that market.

In many areas local firms can fill the coverage gap. Ulaanbaatar, Mongolia–based Frontier Securities publishes thematic reports, rather than company-specific research, although its five analysts do cover five foreign-listed companies and one that is traded on the Mongolian Stock Exchange. “Mongolian companies are still at an early stage, and we only want to write about companies where market cap and liquidity are picking up, and the valuation is good,” explains CEO Masa Igata, who launched the firm in 2007. “At this moment it’s very difficult for us to be compensated with Mongolian domestic companies.”

With the exception of Singapore’s Maybank Kim Eng Securities, companies listed on Vietnam’s stock exchanges are covered only by local brokers, according to Fiachra Mac Cana, head of research at Ho Chi Minh City Securities Corp. His firm employs ten sector and two macro analysts who track 60 Vietnamese companies, although there are 20 to 30 more on the firm’s radar.

Accessing data in such markets can be a challenge. “If I’m covering Barclays, there’s so much information on the U.K., the U.K. banking market and Barclays itself that you can analyze yourself to death,” notes RenCap’s Nangle, who is also a financial services analyst. “If you go down the curve to an emerging-market bank like Itaú in Brazil, there’s more opaqueness around the politics and the banking sector,” although disclosure and governance standards are improving. However, “if you start covering Equity Bank in Kenya, the information is a lot less,” he adds.

Covering frontier companies is “real research — on the ground, spending time interviewing managements, looking at trends — as opposed to sitting in a dark room with statistics,” Nangle declares. “You need to be a certain type of analyst to succeed in these markets. You need to be flexible. You need to get your laptop out in an airport and handle the lack of electricity, management not turning up and bad information — and make assumptions around that and come to some kind of conclusion.”

Lack of liquidity is also a concern. Mac Cana confirms that institutional investors have yet to go to Vietnam in droves. “There’s really only a handful of stocks that somebody who wants to buy $20 million to $30 million in a single position can actually buy at the moment,” he says. “It is a challenge for the mainstream pension funds.”

Some money managers have developed their own solutions. Richard Harris, Hong Kong–based founder and CEO of Port Shelter Investment Management, started a $10 million fund last August that invests in the overseas listings of Mongolian companies. Mongolia, he explains, “just seemed to me to be the golden scenario of investing in frontier markets — you had liquidity and you had growth, while frontier markets usually have growth but no liquidity.”

They also have very little correlation with other economies, which is a big plus in the current global economic environment. “They’re generally just focused on whatever domestic market they’re based in, so they’re somewhat ring-fenced,” HSBC’s Brudenell says. “A banking problem in Greece will impact Spain, France, the U.K. and U.S., but it won’t affect the Nigerian banking system or the Qatari banking system. If there’s a problem in the Qatari banking system, it only affects Qatar.”

Ultimately, he says, frontier markets should not be thought of as an extension of emerging markets. “It’s very difficult to generate true alpha in developed markets, and it’s becoming harder to generate true alpha in emerging markets,” Brudenell asserts. “In the frontier markets there are a lot of pricing inefficiencies and a lot of opportunities if you do the research. There’s a lack of information, and unsophisticated investors, so there’s a real opportunity to generate alpha.” • •